Healthpeak Properties, Inc. Q3 FY2021 Earnings Call

Greetings, ladies and gentlemen, and welcome to the Physicians Realty Trust Third Quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. It is now my pleasure to introduce your host, Brad Cage. Thank you. You may begin.

Thank you. Good morning and welcome to the Physicians Realty Trust third quarter 2021 earnings conference call and webcast. Joining me today are John Thomas, Chief Executive Officer, Jeff Tyler, Chief Financial Officer, Deeni Taylor, Chief Investment Officer, Mark Theine, Executive Vice President Asset Management, John Lucey, Chief Accounting Officer, Lori Becker, Senior Vice President and Controller, Ian Cline, Deputy Chief Investment Officer, and Amy Hall, Senior Vice President Leasing and Physician Strategy. During this call, John Thomas will provide a summary of the Company's activities and performance for the third quarter of 2021 and year-to-date, as well as our strategic focus for the remainder of 2021. Jeff Tyler will review our financial results for the third quarter of 2021 and Mark Theine will provide a summary of our operations for the third quarter. Following that, we will open the call for questions. Today's call will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. They are based on the current beliefs of management and the information currently available to us. Our actual results will be affected by known and unknown risks, trends, uncertainties, and factors that are beyond our control or ability to predict. Although we believe our assumptions are reasonable, our forward-looking statements are not guarantees of future performance. Our actual results could differ materially from our current expectations and those anticipated or implied in such forward-looking statements. For a more detailed description of potential risks and other important factors that could cause actual results to differ from those contained in any forward-looking statements, please refer to our filings with the Securities and Exchange Commission. With that, I would now like to turn the call over to the Company's CEO, John Thomas. John?

Thank you, Brad. I have to admit, this may be the most anticipated earnings call I've ever had the opportunity to participate in. Physicians Realty Trust had a landmark quarter in acquisitions, operations, and balance sheet management. The momentum has continued into the fourth quarter as subsequent to quarter-end, we sold our 3 long-term acute care assets at a cash gain, continuing our progress to eventually become a REIT with 100% of our revenue generated by investments in outpatient medical office facilities. Despite the Delta variant COVID spikes, each of our facilities have remained open continuously since the summer of 2020 and rental income collection rates remain near 100%. In March 2021, we shared our expectations of completing $400 to $600 million in new investments during the year, including both acquisitions and development financing. It would have been easy to complete good investments pro-rata throughout the year, but our investors are more interested in DOC making great investments with better long-term accretive returns resulting from our relationship-focused strategy, rather than just meeting a calendar. We appreciate your confidence through the first half of the year while we completed our negotiation with Landmark, and we're patient with our great partner in Scottsdale on our health. While they completed the construction of two of the most recent additions to the DOC portfolio. On October 1st, we announced our agreement to purchase the 15-building Landmark healthcare facility portfolio for $764 million. A Class A portfolio includes 1.4 million square feet with an average building size of 97,000 feet. Each asset is affiliated with a premier health system, including ten new system relationships to DOC. Those include the investment-grade rated University of Florida Health, Beaumont Health, and McLaren Health Care that combine for 40% of the portfolio's tenancy. In total, 74% of the Landmark portfolio is leased to an investment-grade health system. Additionally, the transaction includes a purchase option on another 46,000 square foot on-campus medical office building that Landmark has developed. Currently, with DOC mezzanine capital and their own equity and construction financing that MOB will be completed in 2022. Upon completion of this acquisition, our share of leases to investment-grade health systems as a percentage of our gross leasable space will increase from 64% today to 65% on a pro forma basis. We're excited to add these relationships and assets to our portfolio and are well into the final due diligence and closing process, including the transition of property management responsibilities where applicable. While one or more health systems could exercise their right to match our purchase price or other conditions could prevent us from closing, we do not anticipate a material reduction in this investment opportunity and expect to close the Landmark acquisition by the end of the year. Additionally, the two new HonorHealth medical facilities we acquired were self-developed by HonorHealth. The HonorHealth neuroscience facility located on their flagship Osborne campus has 109,000 rentable square feet and is 100% leased with a weighted average remaining lease term of 7.7 years. The HonorHealth medical office facility is 60,000 square feet on the campus and attached to HonorHealth News and Oren hospital and serves that high-gross submarket northwest of Phoenix. These investments expand our total investments anchored by HonorHealth to eight facilities, totaling approximately 459,000 square feet. We expect to continue to grow with this outstanding investment-grade health system and the physicians aligned with them in the future. With these investments, we now exceed $1 billion of new investments closed or under contract during 2021. DOC's growth has been fueled by our relationship with healthcare systems and physician groups and the developers working directly with those providers. We're focused on access to healthcare for the next 50 years, not the interest rate in the next five years. Our stability and long-term approach to capital and ownership and laser-focused best in industry, customer service, and property management provide us a measurable advantage to sourcing and completing our investments, growth strategy, and goals. We believe investors want access to a publicly traded best-in-class pure play medical office REIT, and we humbly believe all the data identifies Physicians Realty Trust, our board, and our management as the best option for that investment. Before I turn the call over to Jeff to review our financials, we're also excited and humbled to announce that DOC is among Modern Healthcare's 2021 best places to work. Our ranking of 26 in the supplier category represents our debut appearance, earning distinction while serving as the highest-rated healthcare real estate provider among the honorees. DOC wouldn't be graded the best place to work without our exceptional team. And today I want to recognize our very own Mark Diggs, VP of Asset Management, who just began his one-year term as Chairman of BOMA International. His leadership and attention to DOC will not waiver. This recognition and leadership in the commercial real estate industry is a tribute to his professional and personal excellence. And we're blessed to have him on our leadership team. I would also like to recognize Mark Time, our EVP of Asset Management, and one of DOC's founders, who was recently named by Globe Street to the 50 under 40 list of people to know in the U.S. commercial real estate industry. Congratulations, Mark and Mark, and keep up the outstanding leadership to DOC as the providers in the communities we serve. Jeff.

Thank you, John. In the third quarter of 2021, the Company generated normalized funds from operations of $58 million or $0.26 per share. Our normalized funds available for distribution were $55 million, an increase of 5.3% over the comparable quarter of last year. Our FAD per share was $0.24. In the third quarter, the Company delivered consistent performance with same-store NOI growth of 2.5%, and same-store occupancy down 50 basis points year-over-year as strong lease spreads have offset a handful of deliberate non-renewals. The portfolio saw no material impacts at all from the Delta variant, and we continue to collect over 99% of all contractual rents, and accounts receivable balances remained at the lowest levels in the history of the Company. Looking back over the past two years, although we were optimistic that the portfolio would weather the pandemic better than most real estate asset classes, it has performed so well, it has even surprised us. As we continue to invest in building the best tenant base in the industry, refine our credit monitoring process, and dispose of our limited non-core assets like we did with our recently announced LTAC sale, we see no reason why we won't continue to perform even better over the long term. The Company closed $109 million of investments this quarter at an average first-year unlevered yield of 5.4%, highlighted by the off-market acquisition of a newly constructed on-campus medical office building with HonorHealth. In October, the Company closed another $100 million in deals and announced the $764 million Landmark transaction. The 15-building portfolio is 74% leased to investment-grade tenants and not only provides an exceptionally high-quality portfolio today, but also opens the door to ten new health system relationships for future growth. Since many of our acquisitions are repeat deals often directly with health systems, we would expect this latest transaction to provide future benefits as well. We continue to see enhanced demand for medical office properties as private market participants aggressively pursue the product. However, the difficulty of priming these assets away from health system owners is significant, which enhances the value of our existing portfolio as well as our platform. We had a busy quarter on the financing side of the business. We amended and extended our revolving credit facility, pushing the term out until 2025 and reducing our current cost by five basis points. We also took advantage of our upgraded rating profile from Moody's and S&P to issue $500 million in 10-year bonds with a 2.625% coupon. We used a portion of the proceeds to repay our $250 million term loan and expect to continue to build out our long-term debt curve over time as we grow the Company. As of now, we have only $84 million of debt coming due through 2025, providing exceptional financial stability for our investors. We issued $53 million on the ATM in October at an average price of $18.61 as we see the pipeline continue to build for next year. Additionally, we recently signed a contract to sell our three long-term acute care assets for $62 million, eliminating some non-core assets that we bought in the early years of the Company. These were assets that went through the bankruptcy process in 2019 and generated some temporary negative sentiment. While we achieved a 9% unlevered IRR on our LTAC investment, we prefer the risk-adjusted returns of medical office buildings over the long term and capitalize on the opportunity to sharpen our pure-play MOB focus. Following this transaction, medical office buildings will now provide 96% of our overall NOI, an increase of 2% from last quarter. Turning to other relevant portfolio metrics, our third-quarter G&A came in at $9.5 million and recurring capital expenditures were $6.7 million for the quarter. So both are trending towards our full-year guidance of $36 to $38 million for G&A and $25 million to $27 million for CapEx. I will now turn the call over to Mark to walk through some of our portfolio statistics in more detail.

Thanks, Jeff. DOC continues to benefit from our growing operating platform and strong relationships with healthcare partners. Before highlighting our Q3 performance, I'd like to start by recognizing two outstanding recent achievements by the team. First, Physicians Realty Trust was selected by the Institute of Real Estate Management as the 2021 Accredited Management Organization of the Year. The AMO accreditation was established 75 years ago to advance best practices in real estate management at the Company level, with 560 worldwide firms holding this prestigious accreditation. Today, we are exceptionally proud to be at the very top of that list as the 2021 Accredited Management Organization of the Year. Second, we recently announced our inaugural GRESB score of 75 in their 2021 Real Estate Assessment, outperforming the international score of 73 out of 100. In addition, we received a Green Star designation recognizing the team's work implementing and measuring sustainability policies. As these achievements indicate, DOC remains committed to acting as an ESG leader as we accelerate our external growth momentum. We continue to expand our in-house property management and leasing platforms during the third quarter, laying the groundwork for additional cost efficiencies to deliver long-term enterprise value for our shareholders. As an example, our recent off-market acquisition of two newly constructed facilities occupied by HonorHealth are our 14th and 15th real estate investments in the Phoenix, Arizona MSA. Through our in-house management teams, we are excited to expand this trusted partnership with HonorHealth while also realizing the benefit of our management infrastructure through additional property management fees. Looking forward, our management structure is scalable and will continue to benefit from concentration as we invest in top-quality properties and portfolios, like the Landmark portfolio that is scheduled to close in Q4. In the third quarter, we saw the power of our platform and portfolio generate both internal and external growth opportunities led by same-store growth of 2.5%, leasing spreads of positive 4.4%, and an in-house leasing team that saved over $4 million year-to-date in commissions that would have otherwise been paid to outside leasing brokers, assuming a conservative 3% fee. Our same-store MOB portfolio, which again does not exclude repositioning assets, generated cash NOI growth of 2.5% for Q3 in 2021. The NOI growth was driven primarily by a year-over-year 2.5% increase in base rental revenue. Operating expenses were up 7.3% and offset by an 8.4% increase in operating expense recovery revenue, once again demonstrating the insulated nature of our triple-net leases. Year-over-year operating expenses were up $2.2 million overall, primarily due to a $0.8 million increase in property insurance costs and a $0.7 million increase in real estate taxes. Same-store occupancy year-over-year was down approximately 50 basis points as we intentionally vacated several suites this quarter to make room for anchor tenants with stronger credit to expand to better rates and lease terms. Year-to-date, our leasing team has completed nearly 800,000 square feet of leasing activity with an 80% retention rate and positive 2.7% leasing spreads. In Q3, specifically, tenant retention was 72% across 179,000 square feet of lease renewal, with cash renewal leasing spreads a positive 4.4%. To further drive future internal growth, 80% of the leases executed this quarter contained an annual rent escalation of at least 2.5%. Notably, these results were also achieved with limited leasing costs totaling $1.47 per square foot per year across the full volume of consolidated leasing activity, a figure that's much more efficient than industry averages. Our successful net effective rent outcomes are driven by the quality of our assets and backed by the market pressures driving increases in rental rates and construction pricing. As we look at our portfolio moving forward, DOC's investments are diversified geographically, with no one state accounting for more than 15% of rent, and no single tenant accounting for more than 5.7%. Additionally, our investment-grade quality tenants improved to 64.4% in the third quarter, from 62.5% in the second quarter due to the LifeCare portfolio disposition and HonorHealth investment. These metrics and all of our portfolio quality metrics will further improve with the acquisition of the Class A Landmark portfolio that is 74% leased to investment-grade tenants and includes 10 new hospital relationships. The team is focused on the due diligence and integration of this portfolio by the end of the year and overall, we are very excited about growing the DOC portfolio from $5 billion in real estate investments at the beginning of 2021 to nearly $6 billion in real estate investments by year-end. With that, I'll now turn the call back over to John.

Thank you, Mark. Now we'll take your questions.

Thank you. Ladies and gentlemen, please hold for questions. Our first question comes from John Kim with BMO Capital Markets. Please go ahead with your question.

Thanks. Good morning. I'm here with someone from our team. There's a lot happening in the medical office sector today, including HTA announcing its strategic review this morning. I was curious to know your level of interest in potentially participating in a sale process compared to other opportunities that you're observing in the market.

John, we're focused on our core business in acquiring new investments and investment-grade quality medical office buildings and financing developments of those facilities. Again, we see every opportunity that's publicly available and evaluate those, but we don't comment on them to be reached completely. So thanks for the question.

Last quarter you mentioned John cap rates for high-quality portfolios going in the low 5, and I'm wondering if you can update us on this quarter and what you're seeing fully for those assets.

We believe the Landmark portfolio is exceptional and represents the highest quality we've encountered, and we executed the acquisition off-market. Currently, we see other portfolios trading at lower prices in the mid-fours. Nonetheless, the Landmark portfolio was acquired at a favorable price, which we consider better than what would have been achieved through an open marketing process.

Yeah, I was going to ask about that. So the 4-9 was negotiated a while ago. Where would that trade today if it were to be sold? And can you also comment on the refers you mentioned you weren't that concerned about it, but how many assets or what percentage of the portfolio have that option?

Yes. So these were all built purpose-developed for those health systems. I think one was acquired by like Mark in the process of their relationship with the health system. But all of them have a Roper's and where they are on the ground leases. Our Landmark, or both have visited with all the health systems and starting to receive waivers back verbally and in writing. So they still have some time left in their review process, but we expect substantially all of them, if not all of them to waive those Roper's and complete the acquisitions. In your other question, again we're seeing prints of assets sold in the open market portfolio. So on the open market in the mid-fours. Again, we think the Landmark portfolio with specifically with the quality of the billing, the age of the buildings, the walls of the buildings to the health system credits involved, 74% of these buildings are leased to investment-grade health system credit. So, we think we will trade in the mid-four's, but not low four's.

Got it. That's very helpful. Thank you.

Thank you. Our next question comes from the line of Jordan Sadler with KeyBanc Capital Markets. Please proceed with your question.

Great. I believe the previous guidance was in the range of $400 to $600 million. It seems you've surpassed that, so are there any new targets you can share for the rest of the year or moving forward, John, to help us understand the investment opportunity? This will become clearer after the third quarter.

There's a significant amount available in the market, and we are still assessing some opportunities before the end of the year. We are not ready to update our guidance, as we have not exceeded the range of $400 to $600 million. We announced over a billion in investments, which poses a significant challenge with Landmark. Currently, we have three projects ongoing, one of which is set to begin construction in the first week of December. It is a fully leased, attractive facility that we believe will earn accolades in the Minneapolis market next year. Additionally, we have a project in the New York MSA under construction with Landmark, and we now have the option to purchase that building once it is completed next year. We also have projects with investment-grade tenants in the Dallas-Fort Worth area. I anticipate that we will see some completions this year, and the pipeline for the first quarter is shaping up quite well.

Okay. And then can you speak to sort of the financing evolution? Maybe Jeff, you can kind of frame up where you are on leverage right now on a pro forma basis for all this activity and where you expect to be or how you expect to get back into your target range.

Sure. Thanks, Jordan. So if you look at our third quarter on our enterprise debt-to-EBITDA, we were about 5.0 times. Pro forma for all this activity, assuming Landmark closes completely in the fourth quarter, that would bring us to about 6 times debt-to-EBITDA. So that certainly at the higher end of where we've operated historically. However, if you look at our portfolio, we're 65% in investment-grade tenancy. We collected 99% of all our rents during a terrible pandemic. We're effectively 98% triple-net lease. So there's no operating margin risk in there.

We only have 4% to 6% of our leases expiring each year over the next three years. And we've prepaid pretty much all of our debt. So, we only have $84 million of debt to refinance through 2025. So we think we're in an incredibly stable financial position, so we'll leverage trend down from 6 times pro forma. Are we nervous about carrying 6 times debt to EBITDA for some period of time? No, absolutely not. So we will be opportunistic as we look at funding; it will depend a lot on the upcoming pipeline, and we'll just continue to evaluate it.

Okay, that's helpful. Regarding Landmark and the HonorHealth transactions, particularly the recent new construction assets, could you discuss the advantages of investing in medical office buildings at sub-5 cap rates? It might also be useful to explain the growth differences between the HonorHealth assets and the Landmark portfolio, where you expect to achieve a 5.5 cap rate.

Yes, I understand, Jordan. The Phoenix market is very active. We believe the rents in those two buildings are currently below market. We have some shorter-term leases that give us flexibility to adjust and capitalize on the market opportunities. The potential for growth in that area is significantly stronger than the initial cap rate suggests. We have opportunities for further development and acquisitions directly with HonorHealth, which were off-market transactions. These assets were under construction and entered a pre-sale arrangement mid-year, which has affected the timeline for rental income. Jeff can explain the numbers and the ramp-up schedule. We expect to start adjusting rents more aggressively in certain parts of those buildings, which will be beneficial in 2022.

Okay. Thanks for that.

Our next question comes from the line of Jason Edwin with RDC. Please proceed with your question.

Hey, good morning, guys. It sounds like you have an opportunity to potentially drive rent growth higher. You've been holding back space. I was wondering if you could quantify that opportunity.

Yes, Jason, this is Mark. As we discussed in our prepared remarks, we intentionally chose not to renew a few leases this quarter to accommodate our anchor tenants, primarily investment-grade rated hospital systems, which will occupy the entire building. A recent example of this is in Louisville. Year-over-year, we are strategically focusing on certain markets like Phoenix, Orlando, and Dallas, where rental rates are rising above average. Currently, our portfolio is 96% leased, but we see the potential, given that about 1% to 2% of the portfolio, to selectively increase rental rates and drive market rents higher than usual.

Okay. And then as we look into the acquisition pipeline, looking ahead to 2022, obviously 2021 is very back-end weighted. Should we expect anything similar in 2022, given you're still going to be digesting the landmark deal or will it be more evenly spread out throughout the year?

Yeah. Good question. As I said in my introductory remarks, you'd like to 'ratably' during the year. I think back to one of the other questions, we will issue guidance for next year with their next earnings call, but we've been deploying $500 to a $1 billion almost every year, and again, most years it's more ratable throughout the year. This one we just had the opportunity to capture a very large transaction and also to develop the projects that just took longer to complete than we expected. So again, I think hopefully we'll see some more ratable first quarters is building up very nice right now. And we're in negotiations with a couple more development projects which have not commenced yet, probably commenced first quarter and we will be able to include that in our numbers for next year.

Thank you. Our next question comes from the line of Richard Hill with Morgan Stanley. Please proceed with your question.

Good morning, everyone. We've noticed increased interest in medical office from private equity in our channel checks, and I'm curious about your perspective on that. How do you view the competitive pressures? What strategies do you have for driving accretive growth? Would you consider increasing your leverage given your balance sheet? I'm just thinking about the strong outlook for medical office and how you manage allocations in that context.

If you look at institutional real estate investors, whether they be public or private, look across all commercial real estate asset classes. I don't think there's another one maybe, but cell towers that collected virtually all their rents in 2020 and many are still suffering through significant declines in occupancy and high wage labor costs, which don't affect us. And so as you're allocating capital in an institutional investor, it's no surprise that some of the world's biggest private equity firms and non-traded REITs are going to be very attracted to the medical office space and driving appreciation of assets, again, in a 4 or 5 cap rate environment of best-in-class assets. Generally, a 4-cap cap rate going in, but we look at our investments on a long-term IRR basis. So again, those investors that have a 3 to 5-year horizon, be it private equity or other private capital, we think we compete very well against that. We think the health systems are looking for long-term owners with the transparency about a public company and the business model of a public company that wants to create win-win situations and relationships. We think that's how we keep getting repeat business with the likes of HonorHealth and others and had a great long-term relationship with Landmark, and they finally decided just to sell us all their assets. We have great relationships with most of them and look from time to time with potential joint venture opportunities. But for the most part, adding assets to our balance sheet is our primary focus.

That's helpful, guys. I appreciate the call on the unlevered yields for Landmark. Do you have any thoughts or insights on accretion for 2022 or 2023? I know it's early, and you haven't provided guidance. If the answer is no, I completely understand, but I thought I would ask.

Yeah, the answer is generally no, but the Landmark portfolio does have some more vacancy across the portfolio than our portfolio and we're already working on evaluating lease-up opportunities for that space. We were talking about two or 300 basis points, but there are some shorter-walled tenants in some of those buildings and as we talked about before, the market rents are moving more aggressively up in those markets and so again, we expect to take full advantage of those opportunities with those health systems and source new developments with those health systems.

Thank you. Ladies and gentlemen, at this time, there are no further questions. I will turn the floor back to management for closing comments.

We appreciate everybody joining us this morning. We look forward to follow-up calls and Nareit. Unfortunately, Zoom is next week, but we look forward to seeing you one way or the other. Thanks for participating.

Thank you. Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time.